Unemployment is our next economic conundrum

Listen to the latest central bank press conferences, and you get the impression that things are starting to go as planned. Earlier this month, Bank of England (BoE) governor Andrew Bailey said that falling inflation “is what we expected to see. It is good news”, adding that “inflation will continue to fall over the next few months”. In the US, Fed chair Jay Powell sounds equally confident. He sees “the pieces of the puzzle coming together” as inflation eases.

After a disorientating period of high inflation and soaring interest rates, are economies finally starting to behave as normal? If so, unemployment could be about to climb. If textbook economics tells us anything, it’s that there's a direct link between joblessness and inflation rates.

Economists have long been taught that there is an inverse relationship between inflation and unemployment, as set out in the Phillips Curve. The intuition feels sound: low unemployment means competition for workers, which forces firms to increase pay in order to attract labour. This puts upward pressure on costs and prices, and inflation rises as a result. In times of high unemployment, the opposite occurs: a large pool of available workers means lower wages, and less inflationary pressure. In theory, falling inflation comes with a nasty unemployment chaser. 

In the UK, the BoE expects inflation to return to the 2 per cent target by the start of 2025. But unemployment is expected to rise in tandem: the BoE’s projections suggest that unemployment will tick up from 4 per cent today to 5 per cent by 2026. According to James Smith, research director at the Resolution Foundation, “the price for taming inflationary pressures from Britain’s tight labour market is an increase in unemployment of around 350,000”. The think tank said that today’s wage pressures are driving larger interest rate rises, which will contribute to a predicted rise in unemployment further down the line.

But there could be scope for another economic surprise. Dario Perkins, economist at TS Lombard, wrote a few weeks ago about “the mystery of immaculate disinflation”. This is the idea that inflation seems to be resolving despite unemployment remaining low and recession being kept at bay. 

He raises a good point. Even though 5 per cent unemployment would be miserable for the 350,000 workers vulnerable to job cuts, it is low by historical standards – as the chart shows. And when compared to unemployment rates reached following other periods of high inflation, the figure looks lower still. According to Perkins, this has left mainstream economics “in a state of confusion”. He added that “for economists who still believe in the Phillips curve (which unfortunately means most central bankers) this is a riddle, wrapped in a mystery, inside an enigma”. 

But don’t abandon all hope in the discipline yet. Perkins points out that there are some sound economic reasons for this strange behaviour, starting with the peculiarities of the Covid-era economy. He suggests high inflation was driven by pandemic-induced cost pressures, coupled with companies paying generous wages to entice workers back to jobs that they no longer wanted to do. As a result, companies trying to hire workers found themselves unable to find people with the necessary skills or interests, and unfilled vacancies soared. Crucially, this dynamic might have allowed central banks to rebalance the labour market by destroying unfilled job openings rather than actual jobs.

There are further grounds for optimism. In the US, core services excluding housing PCE inflation (a mouthful, but considered a good way of capturing wage pressures) is showing clear moderation. This sounds like a techie point, but it bodes well for the UK. Perkins thinks that the US is “probably six months ahead of Europe in the disinflationary process”; if the US is seeing lower wage pressure without an attendant increase in unemployment, perhaps we can, too. Policymakers could, for once, be pleasantly surprised.